Government Finance
- Government finance covers how the government raises revenue and spends it to achieve macroeconomic objectives. This unit covers the government budget (concept, classification, components)
- deficit financing (concept, objectives, methods)
- fiscal policy (concept, types, objectives, instruments) — the use of taxes and spending to influence the economy.
In this chapter
Government Budget
The government budget is an annual financial statement showing the government's estimated revenue and expenditure for the coming fiscal year. It is the most important fiscal policy document. In Nepal, the budget is presented by the Minister of Finance to the Federal Parliament each year (usually in late May for the fiscal year starting 15 Shrawan / end-July). The budget has three components: revenue (tax and non-tax), expenditure (recurrent, capital, and financing), and financing (domestic and foreign borrowing).
Nepal Government Budget Structure (illustrative)
| Component | Sub-component | Approx. Share |
|---|---|---|
| Revenue | Tax (VAT, income, customs) | 65% |
| Revenue | Non-tax (fees, dividends, grants) | 35% |
| Expenditure | Recurrent (salaries, operations) | 55% |
| Expenditure | Capital (infrastructure, development) | 25% |
| Expenditure | Financing (loan repayment, interest) | 20% |
Budget Classification
Types of Budgets
- Balanced budget — revenue = expenditure. No borrowing needed.
- Surplus budget — revenue > expenditure. The government saves; contractionary effect on the economy.
- Deficit budget — expenditure > revenue. The government borrows; expansionary effect. Most governments run deficit budgets.
- Performance budget — organised by programmes and activities, focusing on outcomes.
- Zero-based budget — every expense must be justified from scratch each year, not based on the previous year.
- Gender-responsive budget — analyses the gender impact of spending (Nepal has adopted this since 2007/08).
Deficit Financing
- borrowing from the public (selling government bonds — does not increase money supply)
- borrowing from the central bank (the central bank prints money to buy government bonds — this increases money supply and can cause inflation)
- borrowing from abroad (foreign loans — creates external debt)
- drawing down foreign exchange reserves
Risks of Excessive Deficit Financing
While moderate deficit financing can stimulate the economy, excessive deficits cause problems: (1) inflation — if financed by the central bank (money printing); (2) crowding out — government borrowing raises interest rates, discouraging private investment; (3) debt burden — accumulating debt requires ever-larger interest payments, reducing funds for development; (4) external vulnerability — foreign debt can lead to a debt crisis if exports can't service it. Nepal's public debt is about 40% of GDP — moderate but rising, with concern about the share of foreign-currency debt.
Fiscal Policy
Fiscal policy is the use of government spending and taxation to influence the economy. It complements monetary policy. Expansionary fiscal policy increases spending or cuts taxes to boost aggregate demand (used during recessions). Contractionary fiscal policy cuts spending or raises taxes to reduce demand (used during booms to fight inflation). The objectives of fiscal policy include: economic growth, full employment, price stability, equitable income distribution, and balance of payments stability.
Instruments of Fiscal Policy
- Government expenditure — direct spending on infrastructure, education, health, defence. Has a direct multiplier effect on income.
- Taxation — direct taxes (income tax, corporate tax) and indirect taxes (VAT, customs, excise). Tax cuts boost disposable income and consumption; tax rises do the reverse.
- Transfer payments — pensions, social security, subsidies. These redistribute income and support consumption.
- Public borrowing — government bonds (domestic and foreign). Affects interest rates and money supply.
- Subsidies — reduce the cost of essentials (food, fuel, fertiliser) for consumers or producers.
Real-Life Example: Nepal's Federal Budget
Nepal's federal budget for FY 2023/24 was about Rs 1,751 billion. Revenue was estimated at about Rs 1,422 billion, leaving a deficit of about Rs 329 billion (about 4% of GDP). The largest spending areas were recurrent (salaries, operations — about 60%), capital (infrastructure — about 24%), and financing (debt servicing — about 16%). Major taxes: VAT (about 28% of revenue), income tax (about 22%), and customs (about 12%). The budget included allocations for federalism — provincial and local governments receive grants from the federal pool. The challenge: Nepal's revenue collection has fallen short of targets in recent years, widening the deficit.
Practice Problem
An economy has the following (Rs billion): Government spending G = 500, Tax revenue T = 400, Consumption C = 800 + 0.8(Y − T), Investment I = 300. (a) Find the equilibrium income. (b) Calculate the government's budget balance. Is it a surplus or deficit? (c) If the government wants to achieve full-employment income of Y_f = 7,000, how much should it increase government spending (ΔG), assuming the multiplier effect?
Canons of Taxation (Adam Smith)
- Adam Smith laid down four canons (principles) of taxation in The Wealth of Nations (1776): (1) Canon of equality — taxpayers should pay in proportion to their ability (income)
- (2) Canon of certainty — the tax should be clear and certain, not arbitrary
- (3) Canon of convenience — tax should be collected at a time and in a manner convenient to the taxpayer
- (4) Canon of economy — the cost of collection should be small relative to the revenue. Modern economists add: canon of elasticity (revenue should grow with income), canon of flexibility (rates can be changed), and canon of diversity (multiple tax sources).
Types of Taxes
| Type | Definition | Example | Progressive? |
|---|---|---|---|
| Progressive | Rate rises with income | Income tax (Nepal: 1–36%) | Yes — rich pay higher % |
| Proportional | Same rate for all | Flat 10% tax | No — same % for all |
| Regressive | Rate falls as income rises | VAT on essentials | No — poor pay higher % of income |
| Direct | Paid directly by person | Income tax, property tax | Can be progressive |
| Indirect | Paid through goods/services | VAT, customs, excise | Usually regressive |
Types of Budget Deficit
- Revenue deficit = revenue expenditure − revenue receipts. Indicates the government is borrowing to cover day-to-day operations
- Fiscal deficit = total expenditure − total revenue (excluding borrowing). This is the broadest measure — the total borrowing needed
- Primary deficit = fiscal deficit − interest payments. Indicates whether the current year's policies create a deficit, excluding the burden of past debt. A zero primary deficit means the government is borrowing only to pay interest on old debt — a warning sign
Real-Life Example: Nepal's Federal Budget
Nepal's FY 2023/24 budget: Total expenditure ≈ Rs 1,751 billion. Revenue ≈ Rs 1,422 billion. Fiscal deficit ≈ Rs 329 billion (4.5% of GDP). Of total expenditure: recurrent (salaries, operations) ≈ 60%, capital (infrastructure) ≈ 24%, financing (debt servicing) ≈ 16%. Major taxes: VAT (28% of revenue), income tax (22%), customs (12%). The deficit is financed through domestic borrowing (bonds) and foreign loans. Concern: Nepal's debt-to-GDP ratio has risen to ~40%, and interest payments consume a growing share — raising the risk of a debt spiral if growth doesn't accelerate.
Key Terms and Definitions
- Government budget: Annual financial statement of estimated revenue and expenditure — सरकारी बजेट: अनुमानित राजस्व र खर्चको वार्षिक वित्तीय विवरण।
- Revenue receipt: Income from taxes and non-tax sources — राजस्व प्राप्ति: कर र गैर-कर स्रोतबाट आय।
- Capital expenditure: Spending on assets (infrastructure, equipment) — पुँजीगत खर्च: सम्पत्तिमा खर्च।
- Revenue deficit: Revenue expenditure > revenue receipts — राजस्व घाटा: राजस्व खर्च > राजस्व प्राप्ति।
- Fiscal deficit: Total expenditure − total revenue (excl. borrowing) — राजकोषीय घाटा: कुल खर्च − कुल राजस्व (ऋण बाहेक)।
- Primary deficit: Fiscal deficit − interest payments — प्राथमिक घाटा: राजकोषीय घाटा − ब्याज भुक्तानी।
- Deficit financing: Borrowing to cover budget deficit — घाटा वित्तपोषण: बजेट घाटा ढाक्न ऋण।
- Fiscal policy: Use of government spending and taxation — राजकोषीय नीति: सरकारी खर्च र करको प्रयोग।
- Progressive tax: Rate rises with income — प्रगतिशील कर: आयसँग दर बढ्छ।
- Canons of taxation: Smith's 4 principles (equality, certainty, convenience, economy) — कर सिद्धान्त: स्मिथका ४ सिद्धान्त।